Testing dominant theories and assumptions in behavioral finance

The purpose of this paper is to empirically test dominant theories and assumptions in behavioral finance, using data from the Standard & Poor's 500 index.

The empirical analysis has three parts: to test the assumption of risk aversion; to examine the dominant theory that the optimal portfolio depends on risk preferences; and to test prospect theory that decision makers prefer certain outcomes over probable outcomes. Finally, an alternative model to test prospect theory is introduced.

The proposed model is more flexible than prospect theory since it does not a priori assume what value of the portfolio induces risk aversion/seeking, while it does not a priori preclude linear preferences. Empirical results show that: investors are risk seeking; a change in the sign of preferences does not necessarily imply a change in the sign of wealth/return and vice versa; and the optimal portfolio does not depend on preferences.

These findings are helpful to risk managers dealing with models of behavioural finance.

The contribution of this paper is that it successfully tests fundamental theories and assumptions in behavioral finance by providing a better alternative to prospect theory in several ways.